If you’ve decided this is the year to sell your property, it’s essential to understand how capital gains will impact your taxes. Unfortunately, many first-time real estate investors and homeowners are surprised to discover – the hard way – that capital gains work a little differently than they thought. So, before you decide to sell, let’s take a gander at how capital gains will impact your decision.
What Exactly is Capital Gains Tax in Real Estate Investment?
Capital gains tax is applied to profits made when selling an investment property. For example, if you paid $1 million for a property and sold it for $1.2 million, your profit is $200,000. The government taxes 50% of your profits, meaning you must claim $100,000 on your income. The remaining $100,000 is yours to keep, tax-free.
However, there’s also something called your “adjusted base cost” (ABC). Your ABC includes costs such as commission and legal fees. Also, if you made any additions or improvements to the property, those costs are included in your ABC.
How Does ABC Impact Capital Gains Tax?
When you sell your investment properties, you need to review all costs related to the purchase. For example, if your purchase price was $250,000, but you paid $7,000 in fees, your ABC would be $257,000. If you sell the property for $450,000, you first deduct the $257,000 from $450,000 to find your profit which is $193,000. You then cut that number in half to understand your taxable gains, which would be $96,500. The $96,500 is claimed as income when you file your taxes, and the balance goes into your pocket.
Now let’s say you also invested $28,000 on improvements for the property. That brings your ABC up to $285,000. Therefore, your profit is $165,000, and the gains you would owe would be $82,500. So, in this case, you claim $82,500 on your taxes, and the other half is yours to keep tax-free.
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How to Reduce Capital Gains Tax When Selling Your Investment Property
There are a few ways you can help reduce the amount of capital gains taxes you’ll pay, including:
- Claiming losses: If you lose money on an investment property when you sell, this is considered a “realized” loss. As a result, you can use your loss to help offset capital gains to help lower your overall tax bill. However, most people don’t realize that capital losses can only be claimed against capital gains.
- Choose the right year for losses: You can apply capital losses to capital gains for any of the past three years. That means if you experience losses for any of the next three years, you can amend prior tax bills and apply unclaimed losses to a year where you’re experiencing capital gains to offset the taxes you owe.
- Carry forward capital losses: You can also carry forward your capital losses for future capital gains, but don’t try this without speaking to a tax expert to avoid doing something you shouldn’t. For example, although capital losses can be carried forward indefinitely, they can only be carried back 3-years.
- Low Income: This is often the best time to sell if you experience a year with lower income than usual. Because your gains are applied to your income, you can reduce the overall taxes owed because you’re in a lower tax bracket.
Do Capital Gains Impact a Principal Residence?
No, capital gains tax is only paid on your investment properties. Homeowners have a Principal Residence Exemption or PRE. However, you have to be very careful when trying to use this exemption as an excuse to avoid paying the legit capital gains tax you owe on an investment property. For example, if you invest in properties, renovate, and then sell them, living in the home during renovations doesn’t mean you can use the PRE. The CRA will eventually spot this pattern and go after you for those profits. In fact, in January 2022, the CRA mailed over 1,700 “educational letters” informing homeowners who had claimed the PRE two consecutive years in a row that they’re not eligible.
What is a Principal Residence?
Your principal residence is any “dwelling” “ordinarily inhabited” during the year. This includes all homes in or outside Canada, including cottages and unconventional homes such as houseboats.
Can Principal Residences Pose a Risk Regarding PRE Claims?
Yes. Unfortunately, several scenarios could put you at risk for a run-in with the CRA when claiming PRE. Here are some examples:
Selling Too Soon
To avoid capital gains tax, you must live in your home for at least two of the last five years you’ve owned the home. Also, the CRA is highly suspicious of homeowners who sell in under two years, as this could be an example of investing in a home, living in it during renovations, and flipping it for a profit.
Since 2016, the CRA has required you to report capital gains from principal home sales on your individual tax return. This includes what’s called a Schedule 3 and a T2091 form designating the property as your principal residence. If you don’t do this for the tax year you sell your home, you could face steep penalties reaching up to $8,000. But, of course, it all depends on how late the proper forms are filed. On top of this, the good old CRA might even deny your PRE, so you end up owing capital gains taxes plus interest despite the property being your principal home.
Once this happens, you trigger a red flag for the CRA, increasing your odds of being audited, a nightmare no one wants to face. So when selling your home, always make sure you understand exactly what steps you need to take to comply with all the regulations that apply for that SPECIFIC tax year. Because the CRA constantly changes tax laws, speaking to a tax expert or knowledgeable real estate agent before you sell will protect you against unintentional mistakes in your tax filing.
Renting Your Home
Another dicey situation is if you rent out a portion of your home or all of it at any given time throughout the tax year. For example, if you decided to rent your house out so you could flee to the country during the pandemic, this can present a serious issue regarding capital gains exemptions. You can get away with short-term rentals for a week or two now and then, but once you get into longer-term rentals with the same tenants over the course of several months, then suddenly, your principal home looks more like an investment property. Also, even if you’re doing short-term rentals, if you’re not living in the home most of the time, you’ll still face issues claiming PRE. Finally, if you claimed gross rental income on past tax filings, that record is with the CRA, and they’ll consider it when reviewing your PRE claim.
Running a Business from Home
The CRA might not honour your PRE claim if you run a business from home. This is because your principal residence needs to be predominantly used as a home at least 50% of the time. If the CRA discovers your home is used for any other purpose more than 50% of the time or more than 50% of the overall square footage, it could present an issue when claiming PRE.
Claiming Capital Losses
With home prices dropping, depending on when you bought your home, you could face a loss if you sell now. However, when it comes to capital gains, you can’t expect to be exempt as a principal homeowner AND benefit by claiming capital losses when you sell your home. The CRA doesn’t permit claiming losses because your home is private property.
Owning an Unusually Large Property
The CRA limits how much land is exempt from capital gains, so if your property is huge, it could reduce how much of the property sale can be exempt. Another example is using part of your property for something other than intended, such as renting the land out to campers or as a community garden. Also, selling parcels of land despite your principal residence being situated there would nullify your PRE for those specific parcels and potentially the entire property.
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How to Dodge CRA Capital Gains Bullets
Always, always talk to a tax expert before making any decisions when selling your property, principal or otherwise. The last thing you want to do is end up on the CRA’s ever-present radar. Although your PRE claim might be completely innocent, the government doesn’t care and can be persistent in making tax evaders pay.
How to Maximize Capital Gains
It would be best to work with a qualified real estate agent who understands investment property sales. They will ensure you maximize your profits by selling at the right time and price. In addition, understanding the inner workings of capital gains tax could help you make wiser decisions when it comes time to sell. Even if you’re considering selling your principal residence, it pays to work with a real estate agent who can avoid tax issues and keep things on track to maximize your profits.
If you’re looking for the best Toronto real estate team to guide you on making wise property investment decisions, call The Christine Cowern Team at 416.291.7372 or email us at firstname.lastname@example.org. We’d love to work with you!